Many of us are not currently eligible for Roth or traditional deductable IRA's. In my situation, I am already contributing the maximum tax deferred amount into my 401K. Therefore, additional investment dollars that I have are not current year tax deductable. And, investing in a traditional IRA that is not deductable is not long-term tax friendly. (i.e. The same invesement that would be taxed at capital gains rates outside the IRA gets taxed at higher current income rates when distributed from within an IRA)

However, my understanding is that in 2010, the tax laws remove restrictions on the conversion from a traditional IRA to Roth. Of course, you still have to pay taxes on the conversion, but the tax payments are spread over two years See here ( I know, not the best source, but free access with no registration

Traditionally, the advice when choosing a Roth vs a deductable IRA is that you choose based on whether you believe your tax rate will be lower now or lower in retirement. But, in this specific case, the advice does not apply, as I have already exhausted the tax advantaged investment options.

So, up until know, I have avoided the nondeductable IRA, preferring to invest outside retirement vehicles. But has the situation changed? The question is, for those in this situation, does it now make sense to invest in a nondeductable IRA with the express purpose of planning to do the conversion in 2010?

Paying taxes on the conversion at that point in time - which will only be on the gains as the original investment was not tax deductable?

Update June 3, 2007

This is my understanding

Please note, that recent clarifications require that you consider your entire IRA holdings, both pre-tax and after tax, in determining the percentage of your total IRA assets that are converted to a Roth IRA.

Therefore, if you have substantial IRA pre-tax monies, you cannot view that you are only converting (to the Roth) funds that are sourced only from accounts that had after-tax IRA contributions. In other words, your funds are by definition, co-mingled

Therefore, for anyone with substantial pre-tax IRA monies, (as I do from a 401K rollover), this strategy is DOA - unless you can and choose to rollover your pre-tax IRA into your company 401k

Thanks for the info. I'm slowly converting a traditional IRA (originally a 401K) into a Roth, a small piece at a time to keep current year taxes low. Looks like I may accelerate that a bit beginning in 2010.

But I don't think it's that great of a break. You still have to pay the full tax, just defer 1/2 of it for a year.

xerty, you said it bette than I did.

I am aware that Congress may take the unlimited IRA conversion away in 2010 - so there is risk

Also, I am aware that I can (and have been) making after tax 401k contributions (my company does not have a Roth 401k) But there is a downside to those contributions. Specifically, when you take a distribution, the earnings are all taxed as ordinary income. If they had been invested outside the 401K, then a large portion of those earnings would be taxed at the far lower capital gains rate.

So, all other things equal, prior to the potential opportunity to do a Roth conversion in 2010, the after tax 401K contribution and the nondeductable IRA contribution are essentially the same. (Except for the fact that you do get more distribution control when you split the after tax contributions into an IRA. The way I understand it, when you take a distribtuion from a 401K you don't get to choose whether you are taking our pre-tax contributions, post tax contributions or earnings. If you split the post contribtions into an IRA you do have more control. The exception to this is that I beleive you still can choose to take a pre-1986 after tax contribtion from a 401K first)

So, perhaps a better way to ask the question is this

Assuming that
1. you are maxing out your pre-tax 401K contributions
2. you have additional post tax income that you can invest
3. you want to invest this additonal post tax income for retirement savings

then what should the strategy be in terms of investment vehicles? Recall that

1. If the funds are invested post tax in a 401k they are comingled at distribution time and the gains are taxed (on a percentage basis) as ordinary income
2. If the funds are invested in a nondeductable IRA the gains are taxed as ordinary income at distribution time, but the current law allows a Roth conversion in 2010
3. If the funds are invested outside a retirement vehicle, the gains are taxed as capital gains
4. If in (2) the one time conversion tax is paid, then gains are not taxed.

Possibilities include
1. Stick with post tax 401k
2. Invest in nondeductable IRA up to the max, additional investements go back to the 401k post tax. Convert IRA in 2010.
3. Just go outside and get taxed at long terms cap rates

xerty said:non-deductible/after-tax 401k contributions. These work basically the same way as the non-deductible IRA (subject to some limits about your ability to convert the 401k money to an IRA without quitting your job, etc)There are no legal limits on your ability to roll over after-tax contributions with related earnings; any limits would be just those imposed by your plan.

There are 2 other things to consider:

1. If you don't want to convert the earnings, you can do a rollover of all pre-tax money from your IRA to your 401(k) before you convert. For example, let's say, in 2010, you have a traditional IRA worth $20,000 to which you've made $15,000 in nondeductible contributions, and a 401(k) to which you've made $40,000 in nondeductible contributions which have grown to $50,000 in value. You could roll over the $50,000 to your IRA, giving you $70,000 in total IRA assets, with $55,000 basis. If you then immediately converted, you would owe ordinary income tax on $15,000 (=$70,000-$55,000). If you wanted, instead, you could roll over that $15,000 from your IRA back to your 401(k), leaving you with a fifty-five thousand dollar IRA [dang obscenity filter!] with the same $55,000 basis, which you could convert and pay no tax at all.

2. Even if the law changes, and even if you can NEVER convert your traditional IRA, making nondeductible contributions is not definitely a bad thing.

IRA withdrawals are ordinary income (excluding basis), and they are basis proportionately (instead of allocating basis to particular assets, so you lose the ability to realize losses or small gains before big gains). If you would otherwise invest in a perfectly tax-efficient portfolio, that can basically transform gain that would be taxed at long-term capital gains rates (currently 15% maximum) into ordinary income rates (35% max) with no other effect. That would clearly be a bad move.

On the other hand, if you would ordinarily hold some bonds (or cash, CD's, etc.), you are much better off making nondeductible IRA contributions, and holding the bonds there, than either holding taxable bonds directly (and paying tax, at ordinary income rates, every year instead of deferring all of the income to when you're retired), or holding municipal bonds (on which you pay an "implicit tax," about 28%, every year in the form of lower yields).

Even if you want a 100% stocks portfolio, and favor highly efficient investments like index funds, it can make sense to make nondeductible contributions (even if you don't expect to be able to convert) -- it gives you the option to hold bonds in your IRA later, if you want.

For those reasons, I've been making nondeductible IRA and 401(k) contributions for several years. In 2010, if the law stays how it is, I will convert all of this money (and will have to think hard about converting the little bit of pretax money), and will have come out way ahead. If I never manage to convert, I'll at least have a bigger IRA to someday hold a more conservative portfolio, and I'll consider myself slightly ahead.

LH2004 said:ellory said:(Except for the fact that you do get more distribution control when you split the after tax contributions into an IRA. The way I understand it, when you take a distribtuion from a 401K you don't get to choose whether you are taking our pre-tax contributions, post tax contributions or earnings. If you split the post contribtions into an IRA you do have more control.No - ignoring the pre-1987 contributions issue, with either a 401(k) or a traditional IRA, the basic rule on withdrawals is the same: every single dollar is considered to be pre-tax and post-tax money in the same proportions as your overall holdings. For this purpose, with a 401(k), you look at all of your holdings in that plan; with IRA's, it's the same, except you treat all your traditional IRA's as a single plan.I agree. My point was that if your pretax contributions are in a 401K and your post tax are in an IRA you have more control at distribution time than if pre and post tax are comingled in a 401k.

As far as rollovers, my current plan does not allow a rollover from an IRA into a 401k - nor, given the broader flexibility of IRA investments would I necessarily want to.

Your point that an IRA gives greater flexibility to change investment vehicles (e.g. change from stocks to bonds) with no tax consequences is absolutely valid. Note, though, that in my case I have other signficant holdings and an anticipated 35+ years of retirement. Therefore I have ample flexibility to change my investment mix in tax sheltered accounts with no tax consequences. As far as holding municipal bonds in an IRA, that seems to me to always be a losing strategy.

I think we're I'm coming out on this is as follows

1. Invest 401k to maximize pre-tax contributions
2. Invest next $4K in nondeductable IRA. This provides the opportunity, given current law, to do a roth conversion in 2010

Then the remaining question is whether additional investments should be in the 401K (post tax) or outside

ellory said:My point was that if your pretax contributions are in a 401K and your post tax are in an IRA you have more control at distribution time than if pre and post tax are comingled in a 401k.Aha, gotcha. However, for those lucky enough to have a plan that's flexible on rollovers (see below), you're better off continuously keeping after-tax in the IRA and pre-tax in the 401(k) via rollovers -- so that a conversion can be truly tax-free, for example.As far as rollovers, my current plan does not allow a rollover from an IRA into a 401k - nor, given the broader flexibility of IRA investments would I necessarily want to.That's unfortunate. It's common for plans to have at least some restrictions on withdrawals (mine, for example, requires them to be spaced 6 months apart -- for no good reason I can think of). Most modern 401(k)'s do allow rollovers in without limitation.

It's probably not worth it for you, but if you really wanted, you could, say, start a side business, with your own solo 401(k) there; make $100 a year or something; get virtually no contributions, but be able to roll your IRA into that.As far as holding municipal bonds in an IRA, that seems to me to always be a losing strategy.What I meant was, holding taxable bonds in an IRA is better than holding munis directly. Lots of people do end up holding at least some munis, or some taxable bonds directly; almost all of those people would be better off if they could have jammed those into an IRA or 401(k), even without a deduction.Then the remaining question is whether additional investments should be in the 401K (post tax) or outsideIf your plan allows withdrawals (including outbound rollovers -- there's no way to restrict just rollovers), then you have no real downside to investing in the 401(k), as compared to the IRA. Yes, it gives you fewer, possibly inferior, choices, but if you can just roll out every after-tax contribution 5 minutes after you make it, then you can just pretend that all of your 401(k) contributions are just nondeductible IRA contributions. So, if you have unrestricted roll-outs, and it's worth making nondeductible IRA contributions, it's almost certainly worth making nondeductible 401(k) contributions too; the major exception would be if you're uncomfortable having so much of your assets in an IRA.

If you expect to be able to roll over and convert within a few years (because you expect the 2010 law to remain at least for that year, or you expect the income limit on conversions to be abolished permanently, or you expect your income to fall back to 5 figures soon), I think it's a no brainer to cram every dollar you can into a nondeductible IRA, including via your 401(k).

If you aren't confident of your ability to convert, then both nondeductible contributions to either a 401(k) or an IRA are a tough call; if you're not looking to expand the "tax-deferred room" to someday hold bonds, I would suggest doing neither in that case.

ellory said:My 401k plan does not allow rollovers, so that option does not work for me.Does it not ACCEPT rollovers, in which case you can't do the trick I've described to siphon pre-tax money from your IRA back into the 401(k)? Or does it not allow WITHDRAWALS of after-tax money? If you can withdraw the after tax money (and related earnings), you can do a rollover, whether they like it or not.

robstrash said:ellory said:Paying taxes on the conversion at that point in time - which will only be on the gains as the original investment was not tax deductable?

I believe that the conversion is the full amount, not the tax deductible only part. This is because I had a regular IRA in the mid to late 90's even though it was not tax deductible. When I converted to a Roth, I had to take the full amount in the conversion (spread over 4 years though). Therefore, I don't think your plan would work as you would have to add the full amount of the IRA to your income. If you make too much to contribute to a Roth (like me), then you are probably at a 25% or higher tax bracket.

I tried going to IRS web site to find the details but after spending 20 minutes reading through docs, just gave up. I would suggest finding out how the Regular --> Roth conversion works as those rules are not scheduled to change.Thanks. I will go reread the regulations, but I can't imagine that you pay taxes on the total conversion amount. Taxes have to be on the total earnings

See here. I suspect that the IRA you converted was a deductable IRA. In effect, the funds converted from the traditional IRA to the Roth IRA that would have been taxable had the distribution not been part of a qualified conversion will be subject to income tax at your normal tax rate. If your IRA consists only of prior deductible contributions and the earnings thereon, the total amount of the conversion will be subject to taxation.

If part of your IRA consists of prior nondeductible contributions, they will not be taxed again at the time of the conversion.As you can see, this says that a nondeductable IRA, having previously been taxed, won't be taxed at conversion time. Only the earnings which have never been taxed

ellory said:As you can see, this says that a nondeductable IRA, having previously been taxed, won't be taxed at conversion time. Only the earnings which have never been taxedThat is correct. The tax due on a conversion is the same as the tax (but not the 10% penalty) that would be due if you withdrew money.Sorry. TO be clearer, my 401k does not allow withdrawals during employment, only loansBummer.

You may want to double check that. With my plan, I have done rollovers of after-tax money a couple of times, and every time, the administrator tells me I'm not allowed to; I have to point out where in the SPD it says I am allowed.

Any chance you will have left this employer by 2010?

OP asked me to chime in on this useful thread, but I'm afraid that I have little to add but a positive rating at this point. I have never been in the happy situation where I was earning enough wage income to contribute after-tax retirement or IRA dollars, so this isn't an area where I have personal expertise.

It does seem to me like OP, xerty, and LH2004 offer a sound analysis of the possibilities here. In particular, LH2004's "trick" is underappreciated and worth repeating:The only trick to it is the fact that, at present, you can roll over pre-tax but not after-tax money from an IRA to a 401(k), which does give you a way to effectively separate the money, and only convert, or withdraw, the after-tax part. I suspect that this "trick" was unintended, but if one wants to preserve the option of moving from IRA to 401/403 plans, it also seems unavoidable. Assuming one has the ability to move funds freely back and forth into one's 401/403 plan, it seems like a method well worth exploiting in anticipation of future flexibility and opportunities to come.

(Typo edit)